What does the future hold for battered banks?

Anyone that has been investing in banking stocks over the past year will probably be nursing heavy losses because the share prices of many leading names have collapsed on the back of the devastating credit crunch.

But it hasn’t just been shareholders in individual companies who have suffered as a result of the problems in the banking sector, as Rebecca O’Keeffe, head of fund management at Interactive Investor, points out. Those investing in funds have also been hit.

"The Equity Income sector, which is home to some of the biggest UK funds and big name fund managers, has been battered over the last year and is down 21% on average," she says. "However, the best performing fund - Threadneedle’s UK Equity Income is only down 10% because it has limited its financial exposure to 18%. However, the worst performing fund, the New Star Higher Income, is down 35% in the year as it’s been hurt by its exposure to banks and other financial stocks."

The fact that banks make up 15.42% of the blue-chip FTSE 100 index of leading shares has added to the general air of gloom. When such a significant chunk is in difficulties it can’t fail to impact on the market’s overall performance. This is illustrated by the figures. The index, which consists of seven banks, has plummeted from 6,590 points to 5,426 over the year to 2 July 2008. This represents a painful 18% fall for investors.

It’s been a time of shock and confusion for investors. So what exactly is going on?

The problem is that the banking industry has been at the very centre of the economic problems that have swept the globe and so has best been avoided, explains Geoff Penrice, a financial adviser at Bates Investment Services. "The sub-prime mortgage problems in the US, the general economic slowdown and falling house prices are the three main reasons why they’ve been struggling," he adds. "Banks have certainly not been the place to be."

The seriousness of the situation was illustrated when three household names announced plans to raise huge sums - by issuing new shares to existing shareholders in a procedure known as a rights issue - to shore up their balance sheets. The Royal Bank of Scotland (RBS) was the first to move, with the launch of a £12 billion rights issue; HBOS revealed it needed £4 billion; while Bradford & Bingley is looking to get its hands on almost £400 million. Barclays is also seeking to raise £4.5 billion and to bolster its balance sheet by issuing new shares to a variety of investors.

Essentially, this is all about owning up to past mistakes, explains Andy Gadd, head of research at Lighthouse Group. "Shareholders in banks have got to accept that, ultimately, they own the banks, and any losses arising from the credit crunch and inadvisable past lending policies have got to be paid for," he says. "The cash injection from a rights issue is designed to ensure the financial strength of banks going forward."

Cap in hand

However, just whether or not these share issues will do the job remains to be seen, warns Nick Clay, manager of the Newton Managed fund, and the big fear now is that banks will once again be knocking on investors’ doors. "The rights issues have not been big enough and we think they will have to come back and have another go," he claims. "These banks have virtually no bad debts at the moment, but this is going to materially change."

While banks in the UK and the US are undoubtedly suffering, Penrice is at pains to point out that not all banks have been equally affected.

"Those which are geographically well-diversified have fared OK, especially those with exposure to strong economies such as Brazil, India and Russia," he explains. "This means that names such as HSBC and Standard Chartered have held up relatively well." In fact, the share prices of both banks are not too far off the levels they were a year ago. This can be considered quite an achievement considering the vast majority of their ‘rivals’ have lost at least half their value over this period.

According to Nick Clay, the explanation for this is that Asia is still in the throes of recovering from the financial crisis that gripped the region a decade ago and, therefore, their banks are at a completely different stage in the cycle. "People haven’t got many mortgages out there and the property market has been fairly subdued," he explains. "At the moment, they also have lots of savings and may well be thinking about taking out loans to fund purchases."

As to the outlook for financials, opinion among the fund management community is pretty divided, according to Rebecca O’Keeffe. "The jury is split, with some very senior fund managers heralding banks as an opportunity," she says. "However, with the UK housing market on the rocks, household debt a severe issue and general stockmarket sentiment poor - as well as the numerous rights issues - it’s a difficult call."

The question is whether the overall outlook is expected to improve over the coming months, and that is unlikely, according to Ralph Brook-Fox, a UK investment manager at Resolution Asset Management, who manages both the Higher Yield and UK Focus funds.

In fact, Brook-Fox says, things are still expected to deteriorate before any improvement takes place. "Valuations are at very low levels but news flow remains pretty terrible, with credit write-offs, capital raising and rising impairments," he adds. "This seems unlikely to end any time soon and we are waiting for the likely big rise in mortgage arrears and defaults before being tempted back in."

Graham Ashby, head of income funds for Credit Suisse Asset Management, is in agreement. The fund group hasn’t got any exposure to the three banks involved in the fund raising, he says, and has been reducing exposure to banks as a whole.

"Instead, we’ve focused our portfolio in companies which have strong balance sheets and where we believe there’s potential for long-term dividend growth," he explains. "To many people’s surprise, this includes many stocks elsewhere in the financials sector, such as Lloyd’s insurer Amlin."

It's not just banks

Here, Ashby raises an important point. The financial sector doesn’t solely consist of banks, but also insurers, life companies, software manufacturers and even property companies. However, although they may not be directly exposed to the problems in the wider economy, many have been found guilty by association.

For example, the share price of ICAP, which is involved in broking services, has come under pressure even though its business remains unaffected by the economic issues. In fact, the fundamentals of the company remain very strong.

"ICAP has no exposure to the problems of the banks, so has been hit for no reason," agrees Clay at Newton. "Eventually, when everything settles down again, there will probably be some very good opportunities for investors."

Bill Mott, manager of the Psigma Income fund, has been far more positive on financials, and has exposure to names such as HSBC, Standard Chartered, Lloyds TSB, HBOS, RBS and Barclays. In fact, banks account for 14% of the assets under management in the £398.2 million portfolio.

"We do not own Bradford & Bingley and Alliance & Leicester, although they may well offer stunning investment opportunities over the next few months," he says. "It’s not our current intention to increase our relative weighting in the banks unless a cataclysmic event occurs. Life assurance remains our biggest overweight relative stance in the fund."

So where does this leave investors? Should you take advantage of the malaise in financials to buy at relatively low levels, or is it best to sit tight for a few more months to see if there are more nasty surprises in store? According to Andy Gadd, it all depends on your financial goals. Anyone looking to cash-in by making a bumper profit through buying and selling over the next few months needs to think again.

"If you’re prepared to take a medium to long-term view - a minimum of five years - then there are potentially some great opportunities in the financials sector at the moment," he says. "I’m a fan of the New Star Global Financials fund. I like the fact that there’s a global remit and Guy de Blonay, the fund manager, has managed the fund since its launch in 2001."

Geoff Penrice agrees. "The fact that these shares have performed badly is no reason not to invest in them," he says. "We know that the best gains are to be made by buying shares which are under pressure and low in value. Assuming the banks don’t go bust, then this is probably a good time to invest."

That might be the case, but the evidence still isn’t compelling enough to make investing in the sector a no-brainer, argues Mark Dampier, head of research at Hargreaves Lansdown. "You shouldn’t be rushed into doing anything immediately," he advises. "The chances are that there could still be further bad news to come, so there’s no need to start panic-buying. There’s still plenty of time."

More about